Talking Points

Is It Time to Sell Your Business?

We often talk with small business owners who are struggling with the decision of selling their business. It is a very difficult and emotional decision to make and as a result business owners spend a lot of time thinking it through. We see people who sell for all different kinds of reasons, but certain patterns have developed over the years. Here are a few reasons that we have seen:

Health Problems

This is never a good one to see, but it is fairly common. As people get older, health problems tend to pop up. Health problems usually result in an exit when a business is really dependent on the owner for its success.

No Passion

As business owners get older, the passion for the day to day management often fades. This may mean they are ready for retirement or they are just burnt out from leading the business for 20+ years.

New Interests

Some serial type entrepreneurs will want to move on to another venture. Once the business is built and is stable, we have seen business owners sell in order to build new businesses or start new projects.

Holding it Back

The skills you need to start a business and get it to $10 million in sales are not necessarily the same skills you need to get it to $20 million in sales. Some owners realize they don’t have the necessary skills to get the company to the next level. They feel like they are holding the business back and look to sell.

No Transition Plan

Mom was working under the assumption that her son would want to run the business some day. When mom finally asks her son, she realizes he wants to be a baker and has no interest in running the business.

Spouse Says So

Here the spouse has usually seen their husband or wife obsessed with the business for 20+ years. The business owner promised that one day they would quit and spend more time with the family. That day has come.

Need to Diversify

Business owners often put all their money back into the business. When it comes time for retirement, any financial planner will tell you it is never good to have all your net worth tied up in one asset.

Partnership Differences

In this example there are usually two owners with significant ownership in a business and one is ready to retire. When the owner who is retiring wants to sell his shares that means the business needs to be valued. After the business is valued the business is more likely to be sold.

These are just some of the reasons we have seen over the years. Sometimes it can be a combination of the above reasons. When considering whether to sell a business, a business owner should do what is best for them. If you are business owner facing one of the challenges above, please let us know. We would love to talk to you.

Lehman Fee Structure

We recently got an email from a business broker asking us what type of finders fee structure we typically use. Our standard finder’s fee structure is based on the Lehman structure. Since that post has gotten a nice response from the business broker community we thought it might be helpful to walk through a detailed example of how the Lehman structure works. For this example let’s assume we have a finder’s fee agreement with a Lehman structure with a business broker, and we end up buying a business that they introduced to us for $10 million. This is is how the agreement would pay out:

$1 million x 5% = $50,000

$1 million x 4% = $40,000

$1 million x 3% = $30,000

$1 million x 2% = $20,000

$6 million x 1% = $60,000

The total fee for this transaction would be $200,000 (or 2% of the sale price) and it would be payable at closing.This fee structure was created in the early 1970’s by Lehman Brothers and it is a very common fee structure for small business acquisitions. We have used this structure with many of our existing portfolio companies. If you are a business broker and you have a business that meets our criteria, please contact us.

Selling to a Private Equity Firm

Brent Earles, an advisor for small company M&A at Allegiance Capital recently wrote an article in President & CEO Magazine about selling a small company to a private equity firm. He encourages small company owners to evaluate a few key factors when evaluating a private equity buyer:

1. Genuine chemistry and shared vision of growth – Is there “chemistry between buyer and seller”? At Hadley Capital we have another test: would you want to have a beer/dinner with the seller? This is obviously a two way street. It is even more critical when the seller retains equity.

2. Clear and effective funding of the transaction – Earles summarizes, “when the owners makes more of a commitment to funding the deal (i.e. seller financing) than the buyer” then maybe the alleged buyer is not the best buyer. Couldn’t agree more on this point, Hadley Capital is a committed capital fund with the money required to get transactions done quickly.

3. Diligent cadence and a commitment to the process – Earles: “deals that drag…often turn into relationships that…end badly” and “a good private equity buyer will get the deal done within a well-cadenced timeline.” Couldn’t agree more. Hadley Capital is slow to enter into LOIs. We take an LOI very seriously and we only sign LOIs when we plan to commit a lot of our firm’s limited resources to closing the deal within 90 days.

4. Fundamental grasp of the company’s industry and business model – Earles asks, “when a PE firm starts asking basic questions about your industry”, maybe its time to be wary. Hadley Capital is not an expert in any of the industries that our companies operate in but our management teams are often industry leaders. We rely on talented management teams to run our companies but we don’t spend a lot of time on any acquisition unless we feel it has good long term potential, as determined by our own research and due diligence.

The only thing I would add to Earle’s list is that sellers should complete due diligence on the private equity buyer. Any competent buyer will turn your business inside out during due diligence. Why not do a little of your own due diligence on the buyer? I am amazed at how few sellers do legitimate diligence on buyers. Ask to talk to other business owners that have sold businesses to the private equity firm, ask to talk to Presidents of their companies. Ask these references if the private equity firm is trustworthy, do they do what they say, how do they treat people, have they helped grow your company, etc. It’s common sense, but rarely executed.

Maybe business owners are blinded by LOIs with big prices and forget that if it’s too good to be true, it probably is. Get good advisors, heed the advice of Earles (his firm has represented many quality companies that Hadley Capital has reviewed over the past 10 years), and do your own due diligence on private equity buyers!

Response to Stage 2 Planning

We recently read Stage2Planning’s post “Is Private Equity For You?” The post points out some things that companies should consider before selling to a private equity firm. While we agree that business owners should think about what they want before selling their business, we don’t agree with some of the points the author makes about private equity. Below are the points we disagree with and why:

“These stakeholders might be your employees, suppliers, the community, or the customers of your company.  Your job moves from only keeping stakeholders happy to maximizing the financial return of the company.”

These two things are not mutually exclusive. The majority of business owners work to keep employees, suppliers, customers, etc. happy AND they maximize the financial return of the company. This is not an either or situation. At Hadley Capital we think the company should do both.

“A private equity firm wants to usually hold your company for five to eight years and then find another buyer to cash them out with a very handsome return. This means you will have to grow your business very rapidly. While growing the business you’ll have to understand that you will need to do this with little cash because the private equity people will not want to put more money than their original investment into your company.”

At Hadley Capital our first order of business after acquiring a company is to “Do No Harm”. We make little to no changes to the business in the first year. We are not looking to make quick changes and then “flip” the company.  Instead, we look to make a couple small changes each year. We also disagree that a company will have “little cash” to grow. When acquiring a company we make sure the company is well capitalized to support growth. We also often put additional capital into the company when making acquisitions.

“Are you aware of the capital structure of your company after you do a deal? A typical private equity deal will have five dollars in debt for every dollar in capital the new investors put into your company. Your company is now on the hook for this new debt.”

We would never do a deal with a 5:1 debt/equity ratio. Our typical structure is 2 parts debt to 1 part equity. It is also disingenuous to suggest that “the company is on the hook for this new debt”. In most of our companies, we own the business in partnership with management – we are all in this together.

“If you have a bad year the private equity firm you thought was in your corner may quickly move to being an adversary. Your agreement with the private equity firm is likely to have a take over clause. This means that if you don’t hit pre-arranged financial performance numbers you will be asked to leave and someone will take your place. Many private equity firms will tell you that everything will stay the same after they make the investment in your company. They will also say that their takeover clause is only reasonable since they have put so much money in your company. Private equity firms have learned that for them to get the financial returns they expect, they will often have to change senior management, including and especially the founder of the company.”

We determine who is going to run the company before the acquisition closes and we support management in running the company. We don’t put in a “take out clause” and the business owner goes into this process “eyes wide open”. For selling a majority stake in their business, they receive millions of dollars. In exchange for the millions of dollars the business owner gives up absolute control of the company but frequently retains a minority share in the business in order to get a proverbial “second bite of the apple”.

“Private equity might be the perfect thing for you. Before you take the plunge, spend some time running your company maximizing the return and economic value of your company. If you enjoy doing this, then private equity could work out well for you. If not, choose another path to having a liquidity event in your company.”

We think it is condescending to tell business owners to “spend some time running your company maximizing the return and economic value of your company”. The majority of businesses are already doing that (or at least trying!). Profit is not a bad word. Most business owners like to make one and we like to help them.

At the end of the day we always tell business owners to do research and due diligence on the buyer (private equity or strategic). It is the only way to get evidence that a buyer does what they say they do.

The Problems with ESOPs

Over the years we have evaluated a number of small company acquisitions where the target company was deciding between doing an ESOP or selling the business to a financial sponsor like Hadley Capital.

ESOP promoters are quick to point out the significant economic benefits to ESOPs, mostly related to preferential tax treatment of ESOP contributions and distributions. However, there are a number of problems with ESOPs that are not immediately transparent to small businesses. We have developed a list of problems with ESOPs based, in some cases, on first hand accounts of companies that we were evaluating.  Here are a few:

1. ESOPs are complex and expensive – ESOP is an acronym for Employee Stock Ownership Plan. ESOPs are qualified, defined contribution, employee benefit plans that are regulated by the Employment Retirement Security Act of 1974 (better known as ERISA) and, thus, subject to byzantine rules. The ESOP Association itself suggests that “plan sponsors consider the following”:

– Seek professional help in designing the ESOP documents including the Plan Document.
– Strictly adhere to fiduciary structure and document all governance steps and decisions.
– Continually review the investment of employer stock and develop a list of factors to be reviewed. Follow and update that list as appropriate.
– Communicate accurately when discussing employer stock with employees and make sure they are clearly advised of the risks inherent with an employer stock investment.
– Consider engaging in an independent trustee to serve participant interests, or a qualified outside firm for plan administration and record keeping. Request indemnification from outsiders for any errors they may make and obtain evidence of their errors and omissions insurance policy.
– Purchase adequate Fiduciary Liability Insurance.

Sound simple enough? It’s not. That’s why promoters of ESOPs are paid handsome fees to establish ESOPs and to manage ERISA compliance on a going forward basis.

2. ESOPs have repurchase obligations – Employees can require ESOPs to repurchase their stock when they leave the company. These repurchase obligations must be completed at the company’s current ESOP valuation, may put pressure on the company’s cash flow, and are out of control of company management. This can limit a company’s operating flexibility and balance sheet capacity – rather than investing in attractive growth opportunities a company may be required to maintain balance sheet capacity to fund repurchase obligations.

3. ESOPs can fail and create legal exposure for trustees – Many ESOPs are formed so small business owners can realize cash proceeds from an ESOP “sale”. The tax advantages of ESOPs (tax deductibility of principal payments on debt) often result in ESOP “sales” that utilize a substantial amount of deb. Debt can restrict operating flexibility and, in conjunction with a recession or loss of a major customer, can lead to the failure of a company. In this outcome, the trustees of the ESOP (often the business owner that set up the ESOP) can face substantial legal exposure from members of the ESOP.

4. ESOPs are difficult to unwind – The unique structure of ESOPs make it incredibly complex to unwind or sell an ESOP company and/or to raise outside capital for an ESOP company.

Unlike selling a closely-held small company, selling an ESOP company can be like selling a quasi-public company. ESOP participants have broad voting and information rights and trustees of an ESOP are required to “maximize shareholder value” – a difficult concept to prove in the sale of small business.  If a single ESOP participant feels like any of the above requirements are violated, even a well conceived transaction can be derailed or squashed. A more detailed outline of these problems is available here. http://www.faegrebd.com/2646

5. Raising equity capital for an ESOP company can also be very problematic – ESOP companies must be valued on a regular basis in order to establish a value of the ESOP stock.  These valuations establish a baseline that must be considered when evaluating an equity capital raise. If the valuation is too high (from the perspective of capital sources), it will be difficult to raise outside capital. If the valuation is too low, the ESOP trustees may face disgruntled ESOP shareholders, who face dilution from the new equity capital, opening up the trustees for risks described in #3 above. 

ESOPs can be a nice exit strategy for some small business owners but they are not perfect for every situation. Small business owners should complete their own due diligence prior to entering into an ESOP arrangement – including talking to successful and unsuccessful ESOP companies. We’d also be willing to share our own experiences with ESOP companies and discuss other ways of addressing the exit goals of a small business owner.

The 45/70 Rule in Small Company M&A

Over the years, Hadley Capital has developed an age-based rule to help us screen potential deals: if the owner/operator of a small company is less than 45 years old or more than 70 years old, the seller is not sincerely interested in selling at a market valuation.

Owner-Operator:  this rule only applies to an owner who works at their company; it does not apply to absentee owners.

Age:  Younger owners (less than 45 yoa) are only interested in selling if they get a “huge” price for their company.  Otherwise, they prefer to continue running and owning their company.

Older owners (70+ yoa) are often so passionate about their business that they can’t see themselves retiring in order to play more golf, spend more time with their grandchildren, etc. Their personal identity is so closely tied to their company that is difficult to separate the two.

Market Valuation:  Both younger and older owners will sell if the price is way more than the business is worth – both on a market basis and what the owner thinks it’s worth. Few buyers, including Hadley Capital, are in the business of over-paying for companies.

Like any rule, there are exceptions and we have seen a few over the years, generally related to severe health issues. The owner-operator is diagnosed with disease X and needs to get his ducks in a row. Of course, this is never an ideal time to sell a business.

If you are an owner-operator who is less than 45 years old or more than 70 we would still like to speak with you, but please be prepared to convince us that you are a sincere seller.

Exclusivity in Small Company M&A Transactions

I spent an hour on the phone today explaining to a small business owner why it is important to a buyer to receive a period of exclusivity when entering into a Letter of Intent with a seller.

This particular seller thought Hadley Capital should “set up escrow” – place a $50,000 deposit to show our serious intent to acquire his business. I explained that rather than a deposit, I would need a 90 day period of exclusivity in order to 1) confirm the seller’s serious intent to close the transaction with Hadley Capital and 2) spend my limited resources (time and money) on working towards closing the transaction.

After Hadley Capital signs a letter of intent with a business owner, we will spend literally hundreds of hours of our time working to close the transaction. As a result, we don’t enter into Letters of Intent unless we plan on closing the acquisition (assuming everything checks out in due diligence). And, since Hadley Capital acquires only two or three small companies each year, we can’t afford to spend hundreds of hours on an acquisition only to have a seller decide he is going to sell the business to another buyer. Thus our need for exclusivity.

We also spend a substantial amount of money when working to close an acquisition (well in excess of this seller’s proposed $50,000 deposit). Hadley Capital hires professional accounting due diligence teams to complete accounting due diligence, we pay for third-party background checks, we may fund independent market analysis or purchase market research, we retain attorneys to draft transaction purchase documents and debt financing documents. These expenses easily exceed $100,000 per acquisition. If an acquisition falls apart because a seller decides to sell the business to another buyer, my partners and I pay these fees out-of-pocket. Again, we need exclusivity.

Any serious small company buyer will require a period of exclusivity when signing a Letter of Intent. The costs associated with closing a transaction are simply too high not to receive exclusivity. If a seller has serious concerns about granting exclusivity to a particular buyer, the seller should conduct a little more due diligence on the buyer before entering into a Letter of Intent.

Second Bite of the Apple

Hadley Capital has had a lot of success acquiring small businesses in recapitalization transactions. In a recapitalization, the selling owner receives substantial cash at closing and retains a minority equity position. This minority equity position provides the seller with an opportunity to participate in the future success of the business – the proverbial second bite of the apple.

When we acquired Kelatron back in 1999, the selling shareholders kept a portion of the company so that they could share in the continued success of the business. Last month we sold Kelatron and these shareholders received significant proceeds – more like another entire apple than just a second bite.

Hadley Capital has years of demonstrated success acquiring small businesses, improving them, and creating significant equity value upon exit.

If you are a small business owner who would like some liquidity so that all your eggs are not in one basket, and would also like to share in the continued success of your business, call us to talk about a recapitalization of your business. We didn’t just fall off the apple truck yesterday.

Small Company M&A Due Diligence – We’re Sellers, Too!

Before Hadley Capital invests in a company we conduct due diligence.  We seek to learn as much as we can about the business to avoid surprises and be ready for the future, whatever that may bring.  The due diligence process can be rather exhaustive, especially on a business owner who hasn’t been through it before.

But the shoe is often on the other foot.  Hadley Capital is not only a buyer of companies, but also a seller.  We know what a good due diligence process looks like – one that is complete but not unreasonable.  When we are buying, we do not ask any business owner to do things in due diligence that we ourselves are not willing to do.

I have spent the past month selling one of our companies.  In this case the buyer was a public company, and I can safely say that its due diligence makes Hadley Capital’s seem like the minor leagues!

Managing Service Providers in Small Company M&A

Hadley Capital relies on various service providers to help us do our jobs – attorneys, accountants, environmental consultants, etc.  We have long relationships with a number of fine firms.  These people are experts in their fields and we value their input.

We look to our service providers to give advice and make recommendations, but at the end of the day ‘the buck stops here.’  Hadley Capital is the decision maker.  We don’t let our service providers make decisions for us, especially on key issues.

Unfortunately, we’ve seen instances where sellers have let their advisors take over the sale process.  They say things to us like “I know you’re right, but I have to defer to my lawyer on this – he’s the expert.”  This is frustrating, especially since service providers can have different motivations from their clients (increased billings, the loss of a good client on sale, etc.).  Or the advisor might just be trying to be a ‘fierce advocate.’  Regardless, if the decision maker is not the seller this often leads to trouble.  We’re working on a transaction right now where the seller’s attorney fancies himself the business person/decision maker and it’s a mess because he and his client don’t necessarily see eye to eye.

It’s essential to use good service providers.  They help business people make good, informed decisions.  But at the end of the day it’s the business owner’s responsibility to make the key decisions, not the other way around.

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